On cutting the corporate tax rate, GOP must go permanent or go home

Republicans are eager to cut the 35 percent corporate tax rate. Permanently cutting the tax rate — one of the highest in the world — would be a good way to grow the economy. Unfortunately, some Republicans are talking about making the rate cut temporary.

A temporary rate cut would be worse than no rate cut at all. Not only would a temporary cut do nothing to lower long-run tax burdens, it would actually raise taxes on some investments made while it is in effect. Rather than encouraging new investment, a temporary cut would primarily give companies windfall gains on investments they’ve already made.

{mosads}Under corporate income tax rules, companies are taxed on the payoffs from their investments, but are allowed to deduct the costs of making the investments. Cutting the tax rate affects both sides of the equation. The taxes on the payoffs go down, but so do the tax savings from the cost deductions.

A permanent rate cut lowers the net tax burden on investment. Because the typical investment’s payoffs are bigger than its costs, the lower tax bills on the payoffs outweigh the smaller tax savings from deducting the costs. The lower tax burden is likely to draw investment to the United States, making American workers more productive and boosting their wages.

A temporary rate cut has very different effects. It can actually raise the net tax burden on new investments, depending on when the payoffs are earned and when the costs are deducted. With a temporary rate cut, timing is everything, as taxes go down only on the payoffs that are earned during the time the rate cut is in effect and tax savings shrink only for the costs that are deducted during that time.

Suppose, for example, that an investment’s payoffs are spread over 20 years, but that the tax rules provide that its full costs are immediately deducted when it is made. If the investment is made shortly after a 10-year rate cut starts, the rate cut reduces taxes only on the payoffs earned during the first half of its life, but shrinks all of the tax savings from the immediate cost deduction. Things are even worse if the investment is made shortly before the rate cut expires. The rate cut then applies to almost none of the payoffs, but still shrinks all of the tax savings from the cost deduction.

The temporary rate cut is somewhat less harmful if the tax rules provide that an investment’s costs are depreciated over a number of years. But the problem doesn’t go away. Because the depreciation deductions are generally claimed earlier than the payoffs are earned, a temporary rate cut still applies to a bigger share of the deductions than of the payoffs, particularly if the investment is made shortly before the rate cut expires. The tax burden on new investments may still rise or may fall only slightly.

Even if the temporary rate cut offers little help for new investments, it reduces government revenue because it lowers taxes on the ongoing payoffs companies receive from investments made before the rate cut took effect. The temporary rate cut primarily gives companies an unexpected gain on their past investments rather than an incentive to make new investments. This helps corporate shareholders, but not the economy.

The need to address the tax cut’s revenue loss has spurred the recent interest in making it temporary. Senate rules protect a temporary tax cut from a filibuster even if it adds to the deficit, but protect a permanent tax cut only if it its revenue loss is offset by other tax increases or entitlement cuts. Some Republicans want to make the tax cut temporary, so that they can more easily use deficit financing.     

Unfortunately, deficit financing would make a temporary tax cut even more harmful. The tax cut would leave a larger government debt in its wake, which would drive up interest rates, impeding investment long after the tax cut expired. Any tax increases that might eventually be adopted to service the extra debt would inflict further economic damage.

A deficit-financed temporary tax cut is no substitute for what the country needs: a permanent corporate tax rate cut with the revenue loss offset by other tax increases or spending cuts. When it comes to cutting the corporate tax rate, Republicans should go permanent or go home.

Alan D. Viard is a resident scholar at the American Enterprise Institute, where he studies federal tax and budget policy. He previously served as an economist at the Federal Reserve Bank of Dallas, the White House Council of Economic Advisers and the United States Joint Committee on Taxation.

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